When dismissing many small cap stocks that I screened as being cheap rather than having value, I was struck by several small and mid cap building and construction stocks that appeared to have all of the characteristics that I am seeking.
For me the ideal investment has a combination of the following
(i) strong valuation characterisitics in terms of asset value, cyclically adjusted PE, cashflow yield.
(ii) a history of having earned sufficient returns and capital to make the business interesting to an equity investor,
(iii) ability for the sales & profitability to grow over time (ie far from peak margins),
(iv) a low risk balance sheet.
My view in this is that the best returns an equity shareholder achieves is when valuations, earnings and leverage are all working in your favour. If I can find many of these characteristics in construction oriented stocks, then why should I not own more of them?
To that end I will be looking at Grafton Group, Heijmans NV and Morgan Sindall plc in greater detail.
There would appear to be a reasonable amount of value on offer. The question then must be, what are the risks? What is the margin of safety? I keep referring to the fact that the market P/B for the broad based MSCI Europe is now at pretty low levels. Now if I were to exclude financials from the market, then there are a pretty small amount of sectors that trade sub book value. Of these construction is the most obvious, in that while it is undoubtedly a cyclical sector there are very many construction companies that have a long hostory of generating strong returns over the cycle. So, it would seem that a P/B of 1 should be a valuation floor as opposed to ceiling. I am not so sure that the same can be said for sectors such as utilities, pulp and paper etc.
I have covered this stock previously, and declined to purchase then. In this post I will take a more detailed look at the valuation and operational dynamics of the business.
The valuation opportunity that presents itself is as follows:
- Grafton has a thru the cycle RoE of 11%,
- The average thru the cycle RoE for peers is 5.4%
- P/B is at 0.56, versus peers at 1.08.
- P/S is at 0.28 versus 0.44 at peer group.
- Graham & Dodd PE is 5 versus 22 for peers.
- Most recent 12mth trailing FCF yield is 12.4%.
By peers I am using the simple average of Travis Perkins, Wolseley and Saint Gobain. By thru the cycle RoE I am using the average ten year earnings per share divided by the most recent book value per share.
A business with yielding 12.4% on margins that are significantly below the cyclical average (let alone) peak, is definitely interesting to me. This is trading at a similar level to many UK retailers and while it has challenges, I am not certain that it faces the same type of operational and financial challenges that many of the UK high street is facing.
Now this is reasonably simplistic level of analysis, and does require further investigation, but it leaves me with the view that if the UK division were to trade on a similar multiple to the peer group, then what you would get the Irish division for free!!
- 71% UK
- 29% Ireland
- UK: 2010 4.1% versus 6.1% average since 2000. H1 2011 margins were 4.5%.
- Ireland: 2010 0.4% versus 9.1% average since 2000. H1 20111 margins were -0.4%.
The in the past 12 months the UK division has reported revenue of €1450m.
Valuing the UK at 0.4x revenue yields a valuation of €580m which is in excess of the present market capitalisation. Thus Ireland is free on a peer group valuation multiple.
Why is Graftons UK business not appropriately valued (or is it)?
Given the recent margin history illustrated in the chart above, it would seem reasonable to value Graftons UK business on a revenue and profit multiple that is similar to Wolseley and Saint Gobain at the very least. Below I submit a basic sum of the parts valuation. I generally dislike the SoP method as it is so arbitrary. Despite the flaw, it does help to capture the undervaluation of the Group, given that the UK business could in theory be valued at the same value as the market capitalisation of the firm. (The is a difference betwen mkt cap and EV< that in this case is about €232m.
|Grafton UK Valuation||€, mill||Peer Multiple||Implied Valuation|
|Share of Depreciation||28.0|
To really crystalise value, Grafton must improve operating margins. While they continue to improve EBIT Margins remain at the lower end of the peer group average. Furthermore, while Grafton does not split out Gross Margin by division, it does appear that most of the heavy lifting needs to be done at the level of operating expenditure. Gross Margins are relatively unchanged from the average gross margin level achieved over time.
To put this into context, since revenue and margins peaked in 2007, Sales have fallen 37.5%, CoGS has fallen almost 36%. During the same time period Operating Expenses have fallen 24%. While the company is trying too cut costs, it does seem that the level of fixed costs is too high for the present level of revenue.
Grafton has cut out a large amount of operatig expenditure in terms of the absolute € amount of costs. Unfortunately, given the decline of revenue it has not been sufficient to fully protect margins.
Staff costs have averaged 13.8% of revenue versus 15.1% during FY 2010. This is despite €124m of costs been taken out (that means job losses – there is a human cost to all of this). SG&A costs have averaged 8.3% over time, versus 9.0% for 2010. Once again this is despite €63m in costs taken out. If I accept that the present cost bases is both fixed and necessary, then revenues would need to grow by 11% to €2.22 billion to return to the average level of margins.
There is a glimmer of hope in the the H1 2011 results revealed that revenue grew by 3% on the year (Not enough, but a start) and operating costs declined such that EBIT grew by 40%. Costs continue to be taken out of the business, slowly but surely. Despite lacking a detailed breakout of costs between each division, it would seem that the UK division is making reasonable progress toward median margins. The problems in Ireland however are not improving. The division remains loss making.
What is Ireland worth?
Ireland now accounts for almost 28% of revenue and is presently loss-making.
- Revenue decline since peak: -53.0%
- Cost decline since peak: -47.3%
- Profit decline since peak: -98.3%
Having reported a small profit in 2010, the Irish business has slid back into loss during H1 2011 as revenue declined by 7.7%. It is too early to say whether a bottom has been reached in terms of revenue outlook. My own suspicion is that Grafton in Ireland is simply operating from way too many outlets even now. I would imagine that some serious surgery is required on the size of the retail estate.
The reality with Grafton is that upside will come from attaching a higher valuation to the Irish portion of the business.
Size of DIY Retail Estate in Ireland
2011: 2.6m sq ft
2010: 2.6m sq ft
2009: 2.6m sq ft
2008: 2.6m sq ft
2007: 2.5m sq ft
2006: 2.3m sq ft
2005: 2.2m sq ft
Now it should be said that not all of the Irish division is accounted for by the DIY division. But the fact that the size of the retail estate has not changed since the market peak while revenue has collapse, would indicate that much should be done to address the cost base. The question then becomes, can something be done?
According to the annual report, there is €900mof operating lease committment due over between 2011 & 2015, with a current year lease rental charge of €59m. To generate a 5% operating margins from the present cost base, revenue would need to grow by 6%. It would seem that we are a while away from that just yet. During H1, one lease has been exited by the company.
It does appear that very little has been done to seriously address the size of the Irish estate. I find it difficult to believe that profitability can recover without rightsizing the business. If managment grasp this issue, I believe that margin and valuation upside could indeed be considerable.
Cashflow and Balance Sheet
The company has done an admirable job in defending cashflow during what has been a torrid time for the company. Much of the efforts to defend cashflow have come from impressive improvements in working capital management. Working Capital/Sales has fallen from 16% at the market peak to 11.5% in the last fiscal year. The company continues to spend on acquisitions and expansion capex (predominantly in Belgium and Poland). This is no bad thing. A reasonable balance sheet and solid cashflow profile supports this, so I see no reason as to why the company should shut up shop on that front. Grafton does split out capex between maintenance capex and expansion capex. That is useful, in that it helps me gauge what a steady state for the business maybe.
Since 2007, creditor days have expanded from 57 days to 73 days. Debtor days have fallen from 61 days to 55days, while inventory days have risen from 65 days to 72 days. All in all the amount of working capital required to finance revenue has declined by €250m. The biggest cash saving has come in the form of pushing out creditor days. I would not bet that it is possible to increase this, furthermore given that many clients are builders and developers I am wondering how much of the debtors book is impaired?
Free cashflow has declined from €194m in 2007 to €75m in 2010, while maintenance capex has declined from €52m to €6m in 2010. I could never understand just how flexible supposedly maintenance expenditure could be. What is admirable however is that the company has continued to generate positive cashflow throughout a very significant compression of business activity.
So, what is this cashflow worth?
I use an backward DCF to estimate what cost of capital is being applied by current cashflow assuming that the cashflow grows into perpetuity at a rate of 0%, 1% and 2%.
I often use DCF’s as a gauge of what is being implied by a share price under as opposed to a predictive tool that depends on a series of ever increasing optimistic assumptions. SO, over time should the average level of cashflow increase and the cost of equity fall, then there could be considerable upside (. . .and vice versa obviously).
The balance sheet is in reasonable shape, with Grafton having spend much of the past 4 years reducing the amount of debt that it has.
|Fix Charge Cover||1.97|
Once lease agreements are factored in, the balance sheet is considerably less strong than first appears however. Credit is due however in that the debt outsatnding has been reduced by €230m in 4 years from cashflow despite a deteriorating operating environment. In addition to the amount of debt been reduced, the maturity of remaining debt has been extended.
Banking covenants are generous in that they allow gearing up to 85% and minimum EBITDA Interest cover of 2x, extending to three times in 2012.
Grafton share price chart
The chart linked above is the most recent price action on Grafton Group. There is a steady shallow downtrend that is in the process of beginning. New recent lows being opened up followed by reasonably uninteresting upmoves. There is some support between 2.15 and 2.40, but following the line of least resistance I am of the opinion to see does it trend toward that level. If that support does not hold, then that would open up the possibility of revisiting the Q1 09 lows – now that would become really interesting from a valuation point of view.
Grafton hasa lot of what I want from an investment:
- Significant upside potential from positive operational leverage,
- Reasonably attractive valuation,
- A much improving balance sheet (2010 F Score was 6, and that improved to 7 on the basis of analysing the interim results).
However I am not moved to buy right now.
- Deteriorating technical picture,
- A margin of safety exists, but not an exceptional one given the ongoing risks in Ireland,
- I have an issue with managemet strategy regarding the Irish retail division (but I except that similar to many retailers they are locked into expensive lease agreements).
I will remain watching, hopeful that I can pick up some stock around €2.15, if not much lower.
Heijmans NV (HEIJM:AEX)
Share Price: €8.14
Graham & DoDD PE: 3.1x
Gearing: 48% (Interest Cover 4.8x)
Heijmans is a listed Property Development, Residential Building, Non-residential Building, Technical Services and Infrastructure company. Outside the Netherlands, Heijmans operates in Belgium and Germany.
In many of the screens that I run, Heijmans, a small cap Dutch construction company keeps appearing. The company has had a torrid time in the past number of years, and required an highly dilutive rights issue during 2009 in order to reduce leverage and shore up the balance sheet. The company has returned to profitability and is once again producing cashflow. A Piotroski score of 8 at the last annual report date indicates that the financial postion is improving. This looks so appealing, on so many fronts.
I will need to do further research, but much of what I see thusfar is exactly what I am looking for in a stock.
Morgan Sindall is a UK housebuilder and construction company. While not as downright cheap as either Heijmans or Grafton, it has a fortress balance sheet and is paying out a substantial amount of cashflow in the form of dividend. Despite having a balance sheet that is heavy with net cash, the median ROE over the past decade has been 21%. All told Morgan Sindall is a stunning company. I need to delve a little further in that I have much to learn with regard to the affordable housing sector – an area that contrubutes a sizable portion of the companys cashflow and returns.
With 53% of the market capitalisation as net cash, I can purchase this company now for book value (yielding 7.6%). This is not a cost of capital business. On the vasisi of a simple DCF or reverse engineered Gordon Growth model, I see no reason why this company should not be valued at twice the present valuation.
I am thinking of Grafton, Heijmans and Morgan Sindall in terms of an investment in small cap European construction related companys. It would be my goal to purchase equal size positions in all three – the thinking being that the lower risk balance sheet of Morgan Sindall acts as a nice counterweight to the riskier ‘recovery’ plays of Grafton and Heijmans.
As usual, comments greatly appreciated.